OTC Derivatives Coming Under Regulatory Scrutiny

More than two years after the near-collapse of the financial industry, the dust finally is settling and sunlight is beginning to pour in. Over-the-counter derivatives — the exotic and mysterious financial instruments that managed to confound even the brightest minds on Wall Street and Capitol Hill — are now being brought out into the open. And many in the industry are on edge.

As regulators draft dozens of new rules to overhaul swaps trading under the Dodd-Frank financial reform law, the industry is coming to the realization that OTC derivatives finally are going to be regulated. The new rules, which are aimed at creating transparency in the nearly $600-trillion global swaps market, will have a major impact on how the buy side executes and clears standardized swaps contracts.

Under the new swaps trading rules, buy-side firms will have the choice of trading standardized contracts either on designated contract markets (aka exchanges) or through a new type of regulated platform known as swap execution facilities, or SEFs. Firms also will be required to post margin through central clearing counterparties, or CCPs.

The new reforms are expected to increase visibility into swaps transactions, open access for investors and smaller dealers to the market through exchanges and SEFs, and produce more bids and offers — all of which is expected to level the playing field for investors. The anticipated proliferation of SEFs for credit default swaps, credit index products and interest rate swaps, however, has raised new liquidity and fragmentation concerns. And while the rules are not finalized yet, regulators are up against a July 15 deadline — a date that many industry participants feel doesn’t provide regulators enough time to get it right.